Does Dubai Matter? Ask Ireland

Presumably the rulers of Dubai and Abu Dhabi are currently locked in negotiations regarding the exact terms that will be attached to a “bailout” for Dubai World.  We’ll never know the details but if, as seems likely, the final deal involves creditors taking some sort of hit (perhaps getting 75 cents in the dollar, at the end of the day), does that matter?

Dubai probably has around $100bn in total liabilities, if we include off-balance sheet transactions, so total credit losses of $30-50bn need to be assigned.  The direct effects so far seem small.  HSBC leads the pack, in terms of exposure,  but our baseline estimate is a 3 percent loss relative to its equity – not good, but manageable (and the stock already fell 5 percent on the news).  The impact among other financial institutions that lent to Dubai seems fairly spread out and mostly within continental Europe.

Korean construction companies and Ukrainian/Russian steelmakers are also affected by the likely fall off in construction activity, but the broader boom in emerging markets is unlikely to be disrupted.  The repricing of risk so far does not apply significantly to East Asia or Latin America.

However, there is a worrying impact on Ireland.

The credit default swap spreads for Irish banks have widened signficantly — even relative to HSBC, with its direct Dubai involvement.  In part, this is hedge funds betting that others will want to insure against the rising risk of an Irish default, but what’s the connection?

The thinking is that a partial bailout – with creditor losses – for Dubai from Abu Dhabi implies something about how Ireland will be treated within the European Union (and the same reasoning is also more vaguely in the air for Greece).  This may make sense for three reasons.

  1. If Dubai can effectively default or reschedule its debts without disrupting the global economy, then others can do the same.
  2. If Abu Dhabi takes a tough line and doesn’t destabilize markets, others (e.g., the EU) will be tempted to do the same (i.e., for Ireland and Greece).  “No more unconditional bailouts” is an appealing refrain in many capitals.
  3. If the US supports some creditor losses for Dubai (e.g., because of its connections with Iran), this makes it easier to impose losses on creditors elsewhere (even perhaps where IMF programs are in place, such as Eastern Europe).

The main effect will be to strengthen the hand of Ben Bernanke in Fed policymaking discussions – so US interest rates will stay low for a long while.  If financial intermediaries draw the appropriate lessons from Dubai, Ireland, and Greece (and Iceland, the Baltics, Hungary, etc), they will be more careful about extending credit to places that are becoming overexuberant – even when it is cheap to increase debt levels.

But an outbreak of caution and care on the part of our biggest banks (and other investment managers) does not seem likely.

By Simon Johnson

36 thoughts on “Does Dubai Matter? Ask Ireland

  1. Financial Crisis part 2. Given the instability in the global financial markets and the fact that nothing was done in the past year to address the fundamental destabling overleverage of all parties, it is likely to be a far off, somewhat randon shock that pushes the system over the edge (again). Think Arch-Duke Ferdinand and WW1 – seemingly insignificant, but neverthe less a tipping point in retrospect.

  2. Nothing seems to have changed and the infamous interconnectedness is still around. Even with certain banks making fairly good profits, any shock is too much for the fragile banking system. Although it’s fragile, it is sound.

  3. It wouldn’t surprise me if they can partially default without there being big repercussions for the time being, as long as Abu Dhabi (i.e. the oil) at least partially backstops it.

    Who’s going to make a beef? Where’s all that money supposed to go? Western consumers are washed up. All the financializers have left are asset bubbles in these emerging countries, and the will-o’-wisp of future consumer hordes there.

    So Dubai World can skate and, as long as the system as a whole can prop itself up for a little while longer, its credit will be good again in no time.

    Who else is everybody supposed to lend to?

  4. Does this mean the leaders of Dubai will have to spend time in their own debtors prisons? I’m not being entirely snarky here. It’s interesting that a country that punishes inability to pay debt so severely can itself not meet its financial obligations.

    I’m surprised that no news organizations have picked up on the irony of this.

  5. Does it matter if the banks take a hit? It should matter – if they do not take a hit, this just reinforces the moral hazard problem that has existed with sovereign borrowing for decades, and there will be no reason for private lenders not to continue to fuel unsustainable growth. But look at the financial institutions we are talking about here. They’ll be taken care of in one way or another. It’s amazing how with sovereign debt situations can evolve where there is little impetus for restraint on either side of the transaction.

    “The main effect will be to strengthen the hand of Ben Bernanke in Fed policymaking discussions – so US interest rates will stay low for a long while.”

    Are you suggesting that our monetary policy is influenced by the financing needs of relatively small states?

  6. “this just reinforces the moral hazard problem that has existed with sovereign borrowing for decades”

    You mean, centuries. Certainly since the Rothschilds. Or the bankers of York. Probably since Roman times.

  7. “The main effect will be to strengthen the hand of Ben Bernanke in Fed policymaking discussions – so US interest rates will stay low for a long while.”

    Maybe the insinuation is that money will flow into US treasuries, US dollars, a safe haven play. Which if true, would be ironic as we see US equities fall as the US dollar strengthens due to it being considered a safe haven. An unwind of the global reserve currency carry trade would be fascinating.

  8. Once burnt, twice fried….. money flowed to the “safe haven” of the USD and treasuries last year because of the 50 year-run of the USD as the reserve currency of the world…. “sound as a pound” was the saying in the 20th century, and the dominant dollar was the place to go in the post WW2 era…. “good as gold” is where money is headed now, as the world looses faith in the fiat currency systems that are interconnectedly tied to shadow-banking nightmares and the central-bank backstops around the world.

  9. Possibly the biggest fallout from this will be the lingering suspicion that the “books” and accounts of a lot of emerging market ventures are not as sound as those with a positive de-coupling spin agenda would like us to believe.
    The ruler of Dubai, Sheikh Mohammed bin Rashid al Maktoum, had been reassuring every one that there were no credit risk problems right up to the time that he had to admit that there were.

  10. It looks like creditors will have to take a hit for sure, the only question is whether western banks get a bigger hit than the local ones.

  11. The media is starting to ask questions about who is on the hook for and Credit Default Swaps relating to Dubai World itself. Undoubtedly, much of the Dubai debt is multiple insured. Have any indications of who might be liable surfaced? What about AIG?

  12. BOND GIRL,
    Your words: “Are you suggesting that our monetary policy is influenced by the financing needs of relatively small states?”

    Ever heard of a place named Kuwait?? That was under H.W. Bush (#41) in case you forgot Bond Girl. It was one of three wars the Republicans never paid for (fiscally or in Bush family lives).

    Dubai is a special case. Anybody at a financial institution involved in evaluating creditworthiness should be able to figure that out. You don’t work at Moody’s do you?

  13. Iceland redux. Small country, little or none natural resources (except air and sand) or financial/industrial history, ueber ambitious financial institutes and megalomanic leaders. Abu Dhabi bails out, up to the next bubble, because one thing we learn from history that we never learn form history.

  14. People are talking about Dubai World as if it is the Sovereign itself. It is not, it is a company owned by the government in charge of property development, rather like National Rail in the UK, or Fannie Mae in the US (now that it has been saved/nationalized). In Dubai World’s case, the debts were explicitly not guaranteed by the government, even though investors assumed otherwise (their memories of Russian MinFins, UK’s RailTrack, Ukraine’s Naftogaz, and other state-owned company defaults nothwithstanding).

    Of course Dubai itself could not save this large company if it wanted to, just like Ireland couldn’t save its banks if they collapsed. But this does not mean that Dubai or Ireland are bankrupt, they can let their equity stake be wiped out and let the creditors reorganize the companies, either taking over or liquidating the assets. The bet that the governments find this politically unacceptable and will bail out creditors is the “moral hazard” that let these guys borrow so much at low rates. Now we will see if unsecured foreign debtholders will be able to find a way to avoid a messy default where they will no doubt find they are powerless in foreign courts, and outmaneuvered locally, as assets are stripped and the company is dismembered. Far better to recognize reality and propose a debt exchange, get 50 cents on the dollar with stronger covenants and some equity warrants.

    The lesson here is that the world is liquid enough and deleveraged enough to take a large default in stride — like CIT a few months ago. More deleveraging is needed to restore solvency, and that is a euphemism for default and debt-for-equity exchanges. Only quite healthy borrowers can deleverage the nice way (by building equity through retained earnings); this is what Simon is saying Bernanke will want to do for banks by keeping ZIRP and a steep YC in place for another year or more, as they continue to take hits in CRE and consumer debts, among other sectors. That should help treasuries, keep weakening the USD, and help commodities and the healthier EM (Asia & LatAm).

  15. From the perspective of the UAE the ultimate Dubai default might present some problems and depending on sagacity some advantages. Abu Dhabi and Dubai together pump around 2.5 million bbl a day. Abu Dhabi has 14 oil fields versus five for Dubai. The big question for the Emirates will be if a hard headed haircut of western Dubai debt holders will impact the price of oil over anything but a short term basis.

    The finance people in charge of the UAE must have a fairly close idea of who is liable to make good on credit default swaps sold covering Dubai defaulted debt.

    Why not let the whole thing sort itself out in the west and offer to take out the debt from whomever must buy the debt as part of a credit default swap settlement? Either way. Take out the debt in a full swap or buy the debt at a discount from debt owners made whole by CDS settlement.

    The ace in the hole is someone must provide funding to conclude construction in progress and find uses for all those under utilized buildings. The present owners of the debt have little value if this aspect of the problem is not a success. Above all they must complete what is underway. The UAE would be forced to put up this capital as a practical matter. As such it is lever to dragoon the present debt holders and those on the hook for CDS payments. Thus, there are delicate timing issues.

    The UAE people must have long been working on methodologies albeit tricky of benefiting from the inevitable default.

    They built a haven for the ultra rich and they find the ultra rich to live and spend in Dubai in the future or find other uses. Certainly, they could s witch over to refining expansion. There is also the tax haven advantage.

    I can see the UAE owning this debt at half or more off and simply putting it to capital of state corporations involved. Then, they must generate revenues from all the infrastructure. If the UAE does not bottle this up, the other Arab states will need to pitch in.

    However , shearing the west must not get in the way of maintaining oil prices over the long term. At all costs the region must contain this default as a working idea.

    Is not the key unknown knowing who makes good on the credit default swaps? After that just what Dubai asset cash flow generation can be expected to service the debt over the long term?

  16. Dubai World is wholly-owned by the government.

    There are many ironies to this situation:

    My question about the Federal Reserve was somewhat rhetorical. If our central bank has to manipulate the yield curve to keep our banks stable, despite the risks associated with that policy, and part of the reason that it has to do so is to offset real or potential losses associated with distressed sovereign debt, that would suggest that the borrowing habits of small states have an influence over our monetary policy (and it should be the other way around). And that should be a very scary thought, which should give our government some incentive to address the issues of moral hazard and capital flows.

  17. UAE also have no capability to support Dubai because they already have 60% debt-to-GDP and if they include Dubai world, their debt/GDP will jump to 100% that will cause the sovereign debt default spiral in Middle East region or even in emerging market.

    The private restructuring is the best choice for Dubai and UAE countries or not the best choice for creditor but this would be the best choice for global market to show that government-holding company will also be restructured under the private method and moral hazard of understanding that government will support all the losses of government-holding companies will reduce or disappear. But one thing we know is wrong is that the credit rating companies tend to give higher rate for the government-holding companies from government support and that is wrong because that is not reflecting the fundamental of companies and credit rating should separate the support of government from the strength of each individual companies.

    Another thing that we can expect is that all central banks policies to inject liquidity failed to tackle to bankruptcy of the companies or even sovereign debt default crisis in the fragile companies or countries because, for example, Dubai world that may have debt near 100 billion with market value of assets that are likely to be lower than book values by more than 30-50%, meaning that Dubai world has already bankrupted. A lot of Dubai assets can never generate cashflow currently but in the future and book value is higher than the intrinsic value that may be from the fraud in the companies or the wrong decision of management.

    The zombie banks and corporate are still a lot in US, Europe, Asia and emerging markets and have never been restructured to improve the capital adequacy or the profitability. We never know the book value is reflecting the real market value of the companies and we could face the unexpected default from here in corporate and sovereign debt default.

    Thanks for Benanke who support the excessive speculation currently in financial world with reduction of the risk aversion of tailed risk, like unexpected default and surely, if there is the unexpected shock like default risk with excessive risk taking without central banks control, we can never avoid the crisis like subprime crisis in the future. Should we support FED creating the subprime speculation with too low interest rate without any regulatory or expert committee audit?

    It is time to tackle excessive speculation and focuses on the real restructuring in the companies and sovereign balance sheets and income statements.

  18. If push comes to shove why would either Dubai the state, Abu Dhabi or the Emirates as a whole make good on the corporate debt of Dubai World?

    The Telegraph article above quotes the corporate debt at $70 bn.

    Dubai itself could put the corporation in a bankruptcy situation wherein the state acts as trustee to operate the business’ of Dubai World so as to preserve the assets. That is, the real estate is now so all pervasive they cannot abandon it and stay viable. Whatever cash flow there is after cash expenses is distributed to the creditors for as long as it takes. If the values of the assets get truly low condemn them out and distribute the money.

    After all, the Rio Grande Southern Railroad was in bankruptcy for around 40 years. They had 1905 bonds with accrued interest never paid that exceeded bond principle by the time they shut down and were scrapped in 1951.

    Dubai the state must do something in 2009 or 2010. The creditors make a deal or they can wait till hell freezes over if the state is unable or unwilling to make good.

    Why not say .. hey people, you bought insurance collect from the insurance company. We are dealing after all with sovereigns at the end of the day. If they cannot pay anyway what else is to be done but telling the creditors so sorry but you wait for the assets to pay off. Sovereign jingle mailing.

  19. Don’t forget Citi. They haven’t seen a bum loan they didn’t like. Since they are running on the taxpayer tab, I guess that means we are picking up the costs of this one, too.

  20. Compliments are due to all for the very intelligent(in the main) comments on this subject. It is refreshing to read enlightened commentary without vitriol. Thanks

  21. Creditors always take a hit, this is no surprise all CB are not as stable or sound as they should be.

  22. One way it seems for the Bank of England to deal with CDS’s is to pump 62 billion “secret” sterling loans into banks like Royal Bank of Scotland and HBOS which they did at the height of the credit crunch. While, surprise, surprise being highly critical of Ireland for implementing its bank guarantee scheme.

    How can anyone trust UK authorities after they indulged in this kind of “secret” dangerous market manipulation. Is this “secret loans” business legal? If it is how can anyone calculate CDS’s? Are secret interventions o.k. if they are for the “right” reasons because that is what is implied.

    It definitely stops investors from making fully informed decisions. Surely,i t opens up government manipulators for legal actions.

  23. The situation where some investors believed that Dubai World debt was guaranteed by the Government, and only discovered that their beliefs were incorrect when DW effectively defaulted, is not new. I believe that a rather similar event occurred, though on a much smaller scale, when a small UK publically owned utility (the Mersey Docks and Harbour Board) went bankrupt in the mid 1970’s.
    However one point which I have not seen is that if Dubai World does not have a sovereign guarantee it is presumably not entitled to sovereign immunity in bankruptcy. Hence creditors outside Dubai can presumably attempt to recover their loans by attaching assets (such as the ports purchased when DW took over P & O) which are outside Dubai. This could make any bankruptcy very messy indeed.

  24. I’ve recently learned MGM Mirage and Dubai World are partners in an $8.5 billion project in Las Vegas called CityCenter.

    According to Bloomberg: “The 67-acre site contains 18.5 million square feet of built space … The largest privately funded construction project in US history … a complex, interconnected web of hotels, condominiums, pools, spas, high-end restaurants and retail outlets, a casino, convention space, ‘pocket parks,’ public artwork and pedestrian walkways.”

    According to Times Online: “no fewer than five ‘starchitects’ were involved in the design process: Norman Foster, Cesar Pelli, Daniel Libeskind, Rafael Viñoly and Helmut Jahn.”

    This is an amazing piece of land development. I take it this might be part of the CRE bubble some are worried will burst. Perhaps a symbol of why everything went so wrong in the financial system.

  25. Thanks very insightful! Hope you could write an article soon on how you think Dubai can restructure its economy.

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